Darvas Box Theory

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on July 12, 2023

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Darvas Box Theory: Overview

Brief Explanation of Technical Analysis in Trading

Technical analysis is a trading discipline employed to evaluate investments and identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume.

It involves the use of various tools and techniques, including chart patterns, to forecast future price movements.

Overview of Nicolas Darvas and His Trading Strategy

Nicolas Darvas, a professional dancer by trade, is well-known in the investment world for turning a $10,000 investment into $2 million within 18 months in the late 1950s.

His trading strategy, known as the Darvas Box Theory, hinges on the assumption that stock price movements occur in distinct stages.

This method focuses on identifying stocks trading within these stages or 'boxes' and capturing the trend as it moves from one box to the next.

Understanding the Darvas Box Theory

Detailed Description

The Darvas Box Theory is a momentum strategy that identifies stocks trading in defined price ranges or "boxes".

Darvas reasoned that when a stock cannot fall below a certain price level (box bottom) and cannot rise above another price level (box top), it's trading within a "box".

When the price breaks out above the box top, it's likely to continue climbing, presenting a buying opportunity.

Volume and Price Action

Volume and price action are critical to the Darvas Box Theory. Darvas used volume as a hint of a possible breakout from the box. When volume increases significantly, it's an indication that investors are showing significant interest in the stock.

On the other hand, price action - the manner in which price changes - helps determine the top and bottom of the box, which are crucial for defining the trading range.

The Construction of the Darvas Box

The Role of Trading Range

In the Darvas Box Theory, the trading range is essential. It is defined by the "box," with the high and low prices creating the box's top and bottom. This range encapsulates the price action of a stock and serves as the foundation of Darvas's method.

Upper and Lower Boundaries

The upper boundary, or box top, is defined by the stock's high price that isn't breached for three consecutive days or more. Conversely, the lower boundary, or box bottom, is determined by a low price that isn't violated for three consecutive days or more.

"Boxes" Within Boxes

Sometimes, within a larger Darvas Box, smaller boxes form. This pattern represents a consolidation phase within the overall trend.

These 'boxes within boxes' can offer additional buy points when the price breaks out of the smaller box and resumes the overall trend.

Darvas Box Theory in Practice

How to Identify a Darvas Box

Identifying a Darvas Box involves spotting a period where a stock’s price is contained within a relatively tight trading range.

Look for the price to touch a certain high point, then retrace downwards but not significantly so before bouncing upwards again. The top and bottom of this range form the box.

Steps to Take When a Stock Moves Out of the Box

When a stock moves above the top of the box on increased volume, this is seen as a buying opportunity. Darvas would only buy if a new box was being formed above the previous one, indicating that the stock price was advancing.

Importance of Trailing Stop-Loss Orders

A trailing stop-loss order is an important component of the Darvas Box Theory. It helps protect profits and limit losses when the stock's price changes direction. Darvas would set a stop-loss order just below the bottom of the current box.

If the stock's price fell and hit this level, the stock would be sold automatically, preserving any gains made or limiting the extent of the loss.

Advantages of Using the Darvas Box Theory

Efficacy in Trending Markets

The Darvas Box Theory is particularly effective in trending markets. This theory allows traders to focus on stocks with strong momentum, providing clear signals when the price breaks out of the box, potentially signaling the start of a new trend.

Minimizes Emotions

One key advantage of the Darvas Box Theory is its capacity to minimize emotional decision-making.

The box and the rules related to it create a disciplined trading strategy, where decisions are based on observable price action rather than instinct or emotional responses.

Identifies High-Momentum Stocks

The Darvas Box Theory is a useful tool for identifying high-momentum stocks.

When a stock breaks out of a box and begins forming a new box higher, it suggests the stock is being driven higher with strong momentum, an attribute that can potentially result in significant profits.

Limitations of the Darvas Box Theory

Inappropriate for Sideways or Volatile Markets

While effective in trending markets, the Darvas Box Theory may not be as useful in sideways or highly volatile markets. The identification of clear boxes becomes challenging when price action is choppy or lacks a clear trend.

Risk of False Breakouts

Another limitation is the risk of false breakouts, where the price breaks the box's top, prompting a buy, but then quickly reverses and falls back within the box or even lower. This situation can lead to a losing trade.

Advantages and Limitations of the Darvas Box Theory

Darvas Box Theory vs Other Technical Analysis Tools

Comparison With the MACD

While the Darvas Box Theory is focused on identifying and trading within price ranges, the Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security's price.

Both can be used to identify potential buy and sell signals, but they provide different types of information and can complement each other when used together.

Comparison With Bollinger Bands

Bollinger Bands are also a type of envelope for stock prices. However, they differ from the Darvas Box as they add standard deviation levels above and below a moving average, creating dynamic bands that widen and contract based on the stock's volatility.

Bollinger Bands are more suitable for identifying volatility and price levels that are overbought or oversold, while the Darvas Box is better for capturing breakouts.

Final Thoughts

The Darvas Box Theory is a unique approach to trading, built on the concept of "boxes" or trading ranges. It is a momentum strategy used to identify stocks trading within defined price ranges and captures the trend as it moves from one box to the next.

The Darvas Box Theory, popularized by Nicolas Darvas in the 1950s, has been a prominent strategy among trend-following traders. This approach's strength lies in its simplicity, discipline, and its focus on price action and volume.

However, like all trading strategies, it's not without its limitations. The theory may not perform as well in sideways or volatile markets, and there's a risk of false breakouts. Therefore, it's recommended to use it in conjunction with other technical analysis tools.

Although the Darvas Box Theory can provide a good basis for trading, it's essential to remember that all trading strategies carry risk.

It's always advisable to seek professional guidance or thoroughly educate oneself before beginning to trade, whether it's with the Darvas Box Theory or any other method. As each trader's situation and risk tolerance is different, what works for one might not work for another.

As such, each trader should find a strategy that best suits their individual trading style and goals.

Darvas Box Theory FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.

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